Challenging a Regulator’s Actions – The ”Arbitrary and Capricious” Standard

By Styskal, Wiese & Melchione

We regularly receive calls from clients regarding various actions by their regulators, and are asked what legal rights the financial institution (“FI”) may have to challenge those actions.

Generally, FI regulatory agencies are granted broad powers by the federal or state statutes under which they are created, and courts and administrative agencies in turn give these regulators wide latitude in exercising those powers.

Regulatory actions usually result from an exam and can take various forms – such as a letter of understanding and agreement, preliminary warning letter, administrative order, or cease and desist order, just to name some.

How does one challenge agency actions? The procedural process varies depending upon the type of action and the regulator, but the FI should first consider the legal standard that must be met in order to successfully challenge a regulatory action in almost all cases—the “arbitrary and capricious” standard.

In sum, the challenger must demonstrate that the regulator’s action is invalid because it was “arbitrary and capricious.” What does this mean? Black’s Law Dictionary defines “arbitrary and capricious” as “[a] willful and unreasonable action without consideration or in disregard of facts or law.” Admittedly, this is a tough burden for the challenger. Let’s look at a few examples.

New York’s Soda Ban

Recently, the New York City Department of Health attempted to enact a “soda ban” that would have restricted portion sizes of sugary drinks, and its validity was quickly challenged. After a detailed review of health records and statistics (and probably due to consumer outrage), a state court judge invalidated the law because it failed to apply equally to all food and drink vendors, and exempted some beverages that contained even more sugar than sodas. This is a rare instance where a judge thought the regulatory action taken was so unreasonable in light of the record that the law was deemed arbitrary and capricious. Notably though, it is not an FI related case.

Vensure Federal Credit Union – Conservatorship

Here is a case much closer to home.

In April 2011, the NCUA placed VFCU into conservatorship, largely based upon its involvement with online gambling businesses (which NCUA had previously questioned), conflicts of interest, and field of membership violations, just to name the big stuff. VFCU’s representatives challenged this action as being arbitrary and capricious. The D.C. Federal District Court found that the NCUA acted within the scope of its process, and had come to a “thoughtful, well reasoned and sound” decision—in other words, the exact opposite of arbitrary and capricious. For obvious reasons, VFCU was an “easy” decision for the court. Let’s look at some closer calls.

United Western Bank – Conservatorship

UWB was placed into conservatorship by the Office of Thrift Supervision (OTS) in January 2011, and the bank’s former directors challenged the action. After a series of legal missteps by the former directors, the case was finally decided in March 2013. The Federal District Court (D.C. Circuit) pointed out that the OTS had voiced concerns about UWB’s “ongoing and significant” financial condition for over a year before the conservatorship. A record of non-compliance with the OTS’s concerns forestalled any finding that the conservatorship was arbitrary and capricious.

Frontier State Bank – Cease and Desist

In 2002, FSB initiated a “leverage strategy” for investments, funding long term investments with short term borrowing. During its regular exams, the FDIC repeatedly warned about specific risk factors that needed to be mitigated. After FSB repeatedly failed to adequately address the regulators’ concerns, the FDIC issued a cease and desist order in 2008 regarding the bank’s investment strategy. FSB appealed, and the matter ultimately landed in Federal District Court in Oklahoma in December 2012. Because the FDIC had repeatedly warned about and documented its concerns about the bank’s insufficient capital, inadequate interest rate risk management, and inadequate liquidity, its action in issuing a cease and desist order was found to not be arbitrary and capricious.

T-Bank CEO – Proposed Civil Money Penalty

In November 2011, the Office of the Controller of the Currency (OCC) filed notice of its intent to assess a $100,000 civil money penalty (“CMP”) against the former CEO of T Bank, Patrick Adams. The OCC’s “beef” with Adams was that T Bank had engaged in numerous “unsafe and unsound” practices centered around payment processing services offered to commercial bank customers creating remotely created checks. After a very careful review of the record (entailing a 155 page report), a federal administrative law judge ruled that T-Bank/Adams had not acted in an unsafe and unsound manner and that the CMP was unwarranted as being arbitrary and capricious. The key factors appear to be that the regulator was aware of the bank’s business line and had, at least informally, approved of it during the course of several exams covering multiple years . . . until suddenly deciding not to approve of it anymore. The “paper trail” supported Adams, as it reflected numerous previous interactions with the regulator about the details of the payment processing services, the bank’s risk mitigation factors related to them and OCC advice regarding policies. Adams also had a paper trail which clearly reflected full disclosure to, cooperation with and adherence to the “requests” of, the regulator. Note that Adams never even needed to go to federal district court—he won at the administrative law level—which is highly unusual.

Thoughts and Strategies

A few thoughts and strategies to consider:

• “On the record,” formal challenges of regulatory actions in the FI industry are usually not successful. Why? Several reasons—the high legal standard, an all too typical pattern of unheeded previous regulatory “warnings,” and a poor paper trail on the challenger’s part.

• On the other hand, informal challenges of regulatory action by FIs can be successful, despite the high legal standard. In our experience, building the record is the key—show the regulator, for example, that objective measurements of risk have been calculated and satisfied, the FI action fits within a quantifiable standard in the industry, the regulator has permitted the practice in similar scenarios, regulatory interpretations support the practice, the FIs key players have a track record of success, etc. An informal challenge often takes the form, in the course of an exam process, of a respectful disagreement with/non-acceptance of an exam finding or document of resolution (which if left unchallenged can lead to the regulator actions described above).

• It is critical to know the key decision makers inside each regulatory agency if an action is to be challenged. What is their track record with similar challenges? Can they be reasoned with informally or is a formal challenge the only option? What is the internal reputation of the initial decision makers? Would an internal agency informal or formal appeal be viewed favorably, based upon the good (or less than stellar) reputations of those decision makers?

• If your FI is looking to challenge an actual or possible regulatory action, informally or formally, it is important to “count the cost”—financially, timewise, and in terms of political capital.

If your FI is facing actual or proposed regulatory action, the experienced professionals at Styskal, Wiese & Melchione can help you plan a “real world” business and legal strategy.